Diversification Explained: Why Combining Investments Can Lower Risk
Holding investments that don't move in lockstep reduces how much a portfolio swings, often without reducing expected return proportionally. Here is the math of correlation and the limits of diversification.
Diversification means spreading money across many investments so that a problem with any one of them doesn't sink the whole portfolio. It's often called the closest thing to a free lunch in investing, because it can reduce risk without a proportional reduction in expected return.
Single-company risk
If you own one company's stock and it fails, you can lose everything. If that same company is one of 500 in an index fund, its failure is a small dent. A hypothetical comparison:
Correlation: how investments move together
The benefit of diversification depends on correlation, a measure of how investments move relative to each other, from +1 (always together) to −1 (always opposite).
Two hypothetical investments each have 20% volatility. A 50/50 mix has volatility that depends on their correlation:
| Correlation | 50/50 portfolio volatility |
|---|---|
| +1.0 | 20.0% |
| +0.6 | 17.9% |
| +0.3 | 16.1% |
| 0.0 | 14.1% |
| −0.3 | 11.8% |
Show the numbers behind this chart
| Correlation between the two investments | Portfolio volatility |
|---|---|
| +1.0 | 20.0% |
| +0.6 | 17.9% |
| +0.3 | 16.1% |
| 0.0 | 14.1% |
| −0.3 | 11.8% |
When the two move perfectly together, mixing them doesn't reduce risk at all. The lower the correlation, the more combining them smooths the ride. Lower volatility also reduces volatility drag, which helps compound returns.
What diversification can and can't do
Can: - reduce the risk of any single company, sector, or country; - smooth portfolio returns; - improve the chance of staying invested through rough periods.
Can't: - eliminate market risk: broad markets can fall together; - guarantee against losses; - keep correlations stable: in sharp market declines, many investments tend to fall together.
Practical ways to diversify
- Broad index funds across many companies; see index funds and ETFs.
- Across asset classes, such as stocks and bonds; see asset allocation.
- Across countries and sectors.
- Limiting concentration in your employer's stock or any single holding.
The takeaway
Diversification lowers risk by combining investments that don't move in lockstep. The lower their correlation, the bigger the benefit. It won't prevent market-wide declines, but it can prevent a single failure from becoming a disaster.
Keep reading
Asset Allocation and Rebalancing: Keeping Your Risk Where You Set It
A 60/40 portfolio left alone through a few good stock years quietly becomes a 70/30 portfolio. Here is how drift happens, what rebalancing does and doesn't do, and the main ways people rebalance.
Guide, 4 min read
Bond Basics: Why Bond Prices Fall When Rates Rise, and What Duration Tells You
Bonds are often described as safe, yet bond funds can lose money. The reason is the seesaw between interest rates and prices. Here is how it works, with prices calculated for three maturities.
Guide, 5 min read
Dollar-Cost Averaging vs. Lump Sum: What the Math Actually Says
If you have a large sum to invest, should you put it in all at once or spread it out? We ran both approaches through three market paths to show who wins, when, and why.
Guide, 4 min read